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david milstead

As the year draws to a close, one of Canada's top IPOs comes from a company that's been in bankruptcy not once, but twice, in the past 15 years.

This time, it's different? The analysts who've initiated coverage on Stelco Inc. in recent weeks say yes, in fact, and that trip through bankruptcy, and the resulting wipe-out of liabilities, is a major reason why.

Investors, however, are getting even further ahead of the analyst community, pushing Stelco shares near the Street's 12-month target prices for the stock. In doing so, they're rewarding Stelco, whose shares debuted at $17 on Nov. 3, for a turnaround that, while plausible, hasn't actually occurred yet. And in doing so, they're setting themselves up for a bumpy ride in case the notoriously cyclical steel sector heads south, the company botches its plan or both.

This is a story with background. Stelco started as the Steel Co. of Canada in the early part of the 20th century; its first trip into Companies' Creditors Arrangement Act (CCAA) restructuring was in 2004, emerging in 2006. The giant U.S. Steel bought it in 2007 and, by most accounts, mismanaged the company straight into bankruptcy again in 2014. It emerged in 2016, with more than 90 per cent of its debts, environmental liabilities and pension obligations wiped out, and its assets were purchased by industry veteran Alan Kestenbaum through his vehicle Bedrock Industries.

Bedrock still owns 85 per cent of the company, and the initial public offering wasn't an exit strategy; it was a refreshingly old-fashioned capital raise, the proceeds of which are to be used on equipment upgrades in its under-capacity mills and improvements on a Lake Erie dock that should enhance the company's prospects to transport its product less expensively by ship.

Indeed, the company seems to have a good idea of what to do; over time, Stelco lost its customers in the higher-margin, value-added automotive market, instead supplying industrial customers who are extremely price sensitive. The plan is to win back auto, but for the near term, Stelco shares will be even more reactive to changes in spot-market prices for "hot-rolled coil" (HRC) steel.

Analyst Curt Woodworth of Credit Suisse, who titled his "outperform" recommendation report "Ride the HRC wave," believes every $20-(U.S.)-a-ton move in the price of hot-rolled coil steel, adds $50-million to Stelco's EBITDA (earnings before interest, taxes, depreciation and amortization). Hot-rolled coil steel, which averaged $522 a ton in 2016 and sits around $620 as 2017 closes, should average around $630 in 2018, he predicts.

It's a compelling recipe for earnings gains: 1) return to past capacity, since the company produced 50-per-cent more steel in 2006 than it did in 2016; 2) bring back the auto customers and sell them those higher-margin products; and 3) benefit from a continuing global rise in steel prices in the meantime.

None of these things have happened yet, however, and while some of these things are baked into the analyst forecasts, investors seem to be betting on all of them. All five analysts covering the company, from firms that underwrote the stock offering, have buy ratings, and their average 12-month target price is $24.25 (Canadian). On Friday, Stelco shares closed down 70 cents, or 3 per cent, to $22.05.

Mr. Woodworth, who has a $24-price target, says "integrated" steel stocks, so named because the companies perform all the steps of steel making, typically trade at six times their forward EBITDA. His target is based on Stelco boosting profit considerably via rising steel products and a better mix of products sold, leading to $364-million in 2019 EBITDA – compared with roughly $200-million this year. (On a net income basis, the company lost about $164-million over the past 12 months through Sept. 30, if you remove a $3.5-billion gain linked to bankruptcy-exit accounting.)

Michael Gambardella of JPMorgan, who has a $25-price target, also bases his work on 2019 EBITDA, $331-million in his estimate, and says Stelco deserves credit for hundreds of million in tax losses that it can use to reduce future income taxes, an asset underappreciated by the market. He places a 5.5 multiple on that EBITDA, arguing Stelco should trade in-line with industry stalwarts AK Steel and U.S. Steel, which have a better base of auto customers but weaker balance sheets.

And Humberto Meireles and Michael Scott of Goldman Sachs, in publishing a $23-price target, said Stelco will deliver superior growth than U.S. steel makers while also offering a far superior balance sheet. "Stelco is a turnaround story, leveraged to the strong momentum in global steel prices," they say.

Yes, a turnaround story it is. We are in the early chapters, however, not the closing ones. And investors who buy in now must consider the possibility of twists and turns, and a less-than-happy ending.